Keeping our eye on the (high risk) ball

Ninth District Highlights - June 2016

I like baseball. It is spring, and I have the fortune of working not far from the Twins’ home field. Unfortunately, I am not a good player; my hitting is particularly bad. My swing is not smooth, and I often can’t see the ball. Coaches telling me to “keep it simple” and “keep your eye on the ball” did not help.

But that advice serves me in my bank supervision job. We should be on the lookout for the simple signs of high risk issues facing banks. Simple but useful signs of risk are concentrations of assets, particularly for asset classes growing quickly in size with rapidly appreciating prices. And this is even more true for assets with a history of rapid declines in value. These lessons were relearned just a few years ago. Supervisors waited too long to respond to those signs in the commercial real estate market (CRE), and in particular construction and land development markets (CLD), before the financial crisis.

We should definitely not make that same mistake so soon after experiencing it. For that reason, the federal banking agencies recently issued a statement reinforcing the need for prudent risk-management practices related to
CRE lending, motivated by growth in such assets along with a weakening of underwriting. One of our main articles in Banking in the Ninth focuses on this guidance, along with some lessons we learned from bank exams in the District.

Is a focus on CRE concentrations justified? A quote from a Federal Reserve and Office of the Comptroller of the Currency analysis of banks with CRE and/or CLD concentrations makes the point:

During the three-year economic downturn, banks with high CRE concentration levels proved to be far more susceptible to failure. … Among banks that exceeded both supervisory criteria, 23 percent failed during the three-year economic downturn, compared with 0.5 percent of banks for which neither of the criteria was exceeded. In particular, 13 percent of banks that exceeded the Construction criterion failed. Banks exceeding the Construction criterion alone accounted for an estimated 80 percent of the losses to the Federal Deposit Insurance Corporation insurance fund from 2007 to 2011.1

CRE and CLD are not the only concentrations on bankers’ and supervisors’ concern list. Agriculture and energy-related concentrations are also feeling pressure (see a longer article on that topic from last year).2 These are the right balls for bankers and supervisors to keep their eyes on.